Investors who use investment trusts are always encouraged to examine out-of-favour themes or sectors – to check whether the fundamentals justify the poor sentiment. This is because trust discounts will usually reflect the prevailing mood – typically being wider than average when sentiment is poor, and narrower when the reverse is true.
Buying trusts when standing on premiums to NAV can be justified, particularly when they are well run and the underlying sector is unpopular. But the better returns occur when a trust is bought at a decent discount and sentiment then improves as it catches up with the fundamentals - the investor usually benefits from both the NAV rising and the discount narrowing.
This is the incentive to rummage in the less fashionable back streets of the investment world. Such an approach has led me to China – a market I have avoided until now.
Poor sentiment
Doomsters can roll off a host of reasons as to why investors should stay clear of the world’s second largest economy. First, the economy is slowing down. Last year it grew by ‘just’ 7.7 per cent - the lowest growth since 1990. Further nervousness focuses on the country’s ‘shadow’ banking sector and resulting credit bubble, particularly debt held by local government, an overheating housing market, and a host of inefficient and large state-owned enterprises.
Overlay this with further, more generic, concerns about corruption and corporate governance, human rights and an increasingly robust foreign policy, at least in ‘home’ waters, and it is not difficult for the pessimists to hold sway – aided in some quarters by an aversion to the political system.
It is therefore no surprise that the market has been a poor performer. Today local markets offer up attractive valuations – around eight times forecast earnings with a 4 per cent yield to boot. Furthermore, with sentiment depressed, the market is under-owned by foreign institutions. Such facts indicate the worst-case scenario is about to happen.
Good fundamentals
However, I suggest the market has got it wrong and sentiment is about to catch up with the fundamentals. The government’s aim of rebalancing the economy away from investment and export-led growth and towards domestic consumption is well documented. This has caused market jitters, particularly as growth has slowed, but it is the right thing to do if growth is to be sustained over the long term.
But what is perhaps less well appreciated is the radical reforms produced, somewhat unexpectedly, from the Communist Party’s Plenum last year - perhaps the most radical in more than 30 years. There was a lot of specific detail, but the central thrust is that the market is being allowed a much bigger role in the economy and state socialism is on the retreat.
Among its many measures, the 20-page plan pledged to scrap price controls, break the monopoly of the state-owned enterprises, further liberalise the financial sector - including allowing private banks to go bust - and create a bigger role for private and foreign companies in a effort to encourage a more efficient allocation of resources.
To a certain extent, this had been quietly happening for some time. But this Plenum gave it added urgency. The Communist Party recognises it needs to increasingly harness market forces in order to satisfy its ever-expectant peoples. The political implications will need to be addressed, but that is not for today.
These are important economic reforms. But just as important, if not more so, is the emphasis being placed on the need to combat corruption and improve corporate governance and the rule of law – including gradual steps towards an independent judiciary and the closing of labour camps.
All things are relative and there are powerful vested interests to tackle. But such reforms could have a profound effect on markets. Investors tend to shun corrupt economies because market forces, corporate logic and asset prices become distorted, the cost of doing business rises, and consequences can include an adverse impact on the protection of minority interests and corporate governance.
It is no coincidence that, prior to the crash of 2008, China’s CAPE (Cyclically Adjusted Price Earnings) multiple rose significantly when the Communist Party set about reducing its appalling levels of corruption, but has retreated since reform ended. This renewed focus on corruption is one reason I prefer China to some other emerging markets, including Russia despite its cheap rating.
It will take time to implement these reforms. China remains a command economy with the five year plan. But early indications suggest the Party’s leadership is deadly serious in its intent, and we should also not underestimate its professionalism. It has already taken action to rein in the property bubble, inflation, the shadow banking sector and local authority debts.
In short, investors should now start buying China. It will not be a smooth ride, but volatility will provide opportunities to add to positions.
Growth portfolio changes
I have introduced Fidelity China Special Situations (FCSS) into the Growth portfolio. Previously run by Anthony Bolton, it is now run by Dale Nicholls who has a strong track record in the region whilst at Fidelity. Gearing of 20 per cent, a focus on small and mid cap stocks, and a discount of 12 per cent all suggest FCSS should do well if indeed the pessimists about China are proved wrong.
This funding has in part been provided by the sales of both Montanaro UK Smaller Companies (MTU) and Jupiter European Opportunities Trust (JEO) – both long-time holdings with very good long term track records. However, performances have tailed off somewhat of late.
While remaining overweight UK smaller and mid cap companies, I have to accept they have had a strong run and may be due a breather relative to their larger brethren. Hence the purchase of Murray Income Trust (MUT) which offers a near 4 per cent yield – MUT is already held in the Income portfolio.
As for JEO, despite the present calm, I cannot help but feel that the markets have not yet finished with the eurozone debt crisis just yet – particularly if deflation does indeed take hold. Suggestions that the ECB will take action via interest rates or even QE may come to pass, and this may be good for equities in the short term. But having enjoyed a strong run in recent years from being overweight the continent, I do not mind taking profits. I can always add to my remaining European holding should volatility return.
Finally, next month I will explain my continued enthusiasm for commercial property and why I have added to both TR Property (TRY) and Standard Life Investments Property Income Trust (SLI).
Otherwise, there were no changes to the Income portfolio during May.
View John Baron's updated Investment Trust Portfolio
| John's book is out now. It explores the merits of investment trusts, the stepping stones to successful investing, and how to run and monitor a trust portfolio. Available from Amazon and other bookshops. For more portfolios and commentary, please visit John's website at www.johnbaronportfolios.co.uk |
